[Tax Story] The COVID-19 Crisis and Tax Administration of Jeoljangbodan (絶長補短)

Baek Jeheum, Lawyer at Kim & Chang

The novel coronavirus disease (COVID-19) pandemic has entered a prolonged phase. The number of confirmed cases worldwide has surpassed 1.5 million, with deaths approaching 100,000. It is a situation of uncertainty with no end to the tunnel in sight. In the first quarter, the U.S. Dow Jones Index fell by more than 24%, and the domestic KOSPI index also plummeted by 20%. Economic analysis agencies have forecasted South Korea's economic growth rate for this year to be as low as -1%. In particular, private consumption has sharply contracted, directly impacting small and medium-sized business owners and self-employed individuals. In a spirit of shared sacrifice, some "Good Landlords" have emerged who reduce rents. To overcome the COVID-19 crisis, an additional supplementary budget of approximately 11.7 trillion won was passed by the National Assembly, and the government announced the payment of emergency disaster relief funds amounting to 9.1 trillion won, providing 1 million won per household for families of four in the bottom 70% income bracket. Special measures have also been implemented in the tax administration sector. The amendment to the Restriction of Special Taxation Act, passed by the plenary session of the National Assembly, includes provisions such as the introduction of tax credits for landlords who reduce commercial rents and corporate tax reductions for small and medium-sized enterprises in special disaster areas. Additionally, local governments such as Daegu are promoting property tax reductions for COVID-19 dedicated hospitals. Regardless of issues of fairness and efficiency, comprehensive efforts are being made across all areas of politics, economy, central and local governments.

While special tax measures are essential for the COVID-19 crisis, reviewing and slightly adjusting the existing tax law framework and mechanisms can also yield significant effects. First, our tax law has various tax support systems in place for natural disasters such as typhoons, floods, earthquakes, and wildfires, but the question arises whether the COVID-19 crisis qualifies as a natural disaster under tax law. For example, the disaster loss tax credit system allows taxpayers who have lost more than 20% of their total assets due to a disaster and are recognized as having difficulty paying taxes to deduct an amount reflecting the disaster loss ratio from their taxes. There is also a disaster loss physical deduction that deducts the loss amount from inherited property if the property is destroyed or damaged by a disaster after inheritance has commenced. In addition, there are provisions for extensions of filing and payment deadlines, collection deferrals, and reductions of additional taxes due to natural disasters.

In the United States, such disaster losses are referred to as Casualty Losses, and regardless of whether the taxpayer is a business operator, losses exceeding $100 per incident and exceeding 10% of the total income for the taxable period due to fire, storm, shipwreck, or other disasters are eligible for income deductions. It is notable that the scope of theft and other accidental losses is broadly recognized. In Germany, income deductions are allowed within the limits of the residual value of acquisition cost or repair costs when asset losses such as destruction or damage are sufficiently closely related to business activities. In Japan, when fixed assets necessary for daily life are damaged by natural disasters, a miscellaneous loss deduction applies. However, infectious diseases like COVID-19 do not cause physical damage to property, making it difficult to apply the disaster loss tax credit system under our tax law. This conclusion is the same under the U.S. Casualty Loss provisions, German income deductions, and Japanese miscellaneous loss deductions. Although collection deferrals and reductions of additional taxes can be applied, their practical effectiveness as perceived by taxpayers is relatively limited.

Instead, attention should be paid to the net operating loss deduction system for businesses or companies experiencing revenue declines due to COVID-19. A net operating loss refers to the amount by which necessary expenses for the taxable period exceed total income for the same period. Such net operating losses can be deducted in two ways. First, a carryback deduction allows the net operating loss of the current business year to be deducted from the taxable income of a 'previous' business year, resulting in a tax refund for taxes already paid. Second, a carryforward deduction allows the net operating loss of the current business year to be deducted from income in a 'future' business year, reducing taxes payable. Our tax law generally applies a 10-year carryforward deduction for net operating losses but exceptionally allows a one-year carryback deduction for certain small and medium-sized enterprises. Strict application of the principle of period taxation adopted by our tax law can cause unfair tax burdens due to fluctuations in income by business year, so the net operating loss deduction system is a mechanism to promote tax fairness.

In the United States, carryforward deductions for net operating losses are broadly applied for 20 years, and carryback deductions for 2 years. Germany and the United Kingdom set the carryforward deduction period indefinitely, and apply carryback deductions of 2 years and 1 year respectively, regardless of small or medium-sized enterprises. Carryback and carryforward deductions for net operating losses can be effective relief measures for businesses and companies experiencing sharp revenue declines due to infectious diseases like COVID-19. Especially, carryback deductions allow immediate compensation for losses by refunding taxes paid in the previous year if income was earned and taxes paid then, even if losses occur unexpectedly in the current business year due to disaster. Therefore, it is worth actively considering revising the tax law provision that limits the carryback deduction to one year only for small and medium-sized enterprises, expanding the scope of application and extending the period to two years. Limiting the application period through supplementary provisions or sunset clauses could be a secondary measure. Proposals to flexibly apply deduction methods or periods considering the cause of the net operating loss are also worth listening to. Emergency disaster relief funds have issues such as being unrelated to disaster damage and lacking urgency, but if net operating losses are identified through quarterly provisional settlements and allow for frequent carryback adjustment claims, it could be a win-win solution. Since tax authorities have the authority to impose taxes at any time, there is no reason why taxpayers facing disasters should not have the right to request frequent adjustments.

Meanwhile, even if emergency disaster relief funds are paid when fiscal conditions permit, there are issues of income tax and gift tax. Under our tax law, which adopts an itemized income concept for individuals, emergency disaster relief funds are not defined as a separate income category, nor are they easily considered other income such as prizes or gratuities, and property received as a gift from the state or local governments is exempt from gift tax, so the possibility of taxation is low. However, emergency disaster relief funds have been criticized for selective payment, which contradicts fairness and timeliness. If such support funds were defined as income and paid immediately to all citizens, then later a progressive tax rate could be applied to high-income earners to recover a significant portion, it could cleverly achieve both fairness and timeliness. The National Tax Service, which has experience implementing the Earned Income Tax Credit system that provides incentives to low-income workers, could effectively perform that role. Furthermore, supplementary measures are needed for future issues such as the issue of entertainment expenses similar to rent reductions and the classification of disaster income. We look forward to a warm spring breeze in tax administration through the wisdom of balancing strengths and weaknesses (絶長補短) in our tax system.

Baek Jeheum, Lawyer at Kim & Chang